Wachovia: A Split May Boost the Banking Industry

The legal battle between Citi and Wells Fargo over Wachovia is suspended, for now. But at least it shows there are assets worth fighting over

For Washington policymakers, the prospect of a grinding, slow-motion legal fight between Citigroup (C) and Wells Fargo (WFC) for the spoils of troubled Wachovia (WB) is clearly unnerving. In a period when the markets seem to come more unhinged with each passing day, regulators fear that a protracted battle in the courts could cause an acceleration in public bank runs. That explains the news reports on Oct. 6 that officials from the Federal Reserve were brokering a compromise that would end with Citigroup and Wells Fargo carving up Wachovia's assets.

If there's any silver lining in the battle between Citigroup and Wells Fargo—and silver linings are hard to come by these days—it is this: The skirmish could help convince the markets that the current panic surrounding banks has gone too far and that even troubled banks like Wachovia have a strong franchise that's worth bidding for. Plus, if Wachovia is split, taxpayers won't have to foot the billions in federal assistance that the original Citigroup deal included.

"Wells Fargo management has performed a real service to the banking industry," Nancy Bush, an independent bank analyst in New Jersey, wrote in a note to clients on Monday morning. "This will mark a turning point for the industry and for the stocks."

If Bush is right, that could mean the era of regulators forcing troubled banks into shotgun marriages—with no recovery for investors in banks such as Wachovia or investment firms like Bear Stearns—could be coming to a close. And the Wells Fargo deal, which Wachovia's board embraced on Oct. 3, prompting Citigroup to sue, could convince investors that for all the bad loans and soured investments these firms are sitting on, acquirers are getting a steal.

Some Old-Fashioned Loans

As Wachovia CEO Robert Steel has argued to Wall Street, only one-quarter of the bank's loan portfolio consists of the troubled mortgages made in its Golden West subsidiary. Excluding those mortgages—admittedly, no small feat—and a smaller portfolio of troubled construction loans, the majority of Wachovia's portfolio consists of old-fashioned consumer loans to customers with whom the bank has generally had a long relationship.

Consider that Wells Fargo's bid for Wachovia (BusinessWeek.com, 10/3/08)—$15 billion, with no government assistance—is roughly seven times what Citigroup agreed to pay (BusinessWeek.com, 9/29/08) for Charlotte-based Wachovia's banking operations the weekend before. And Citigroup's bid included some government assistance. Analysts initially viewed Citigroup's response—a lawsuit, rather than a higher bid—as an effort to shake down Wells Fargo for a "break up" fee for spoiling its own deal. Indeed, Citigroup said Monday that it had filed a suit in the New York Supreme Court against Wachovia and Wells Fargo seeking more than $60 billion in compensatory and punitive damages. Soon after, Citigroup said it had agreed—at the behest of the Federal Reserve—to a standstill of all formal litigation activity.

Still, $60 billion is an outsized sum for a merger that, by its own admission, Citigroup doesn't need. Which means Citigroup's suit is likely just a negotiating ploy to either scare Wells Fargo into scuttling its own deal or to pressure Fed officials to give Citi a great portion of a broken-up Wachovia. And odds are the dispute will still be resolved with some form of a compromise brokered by regulators.

Indeed, in a speech on Monday before the National Association for Business Economics, FDIC Chair Sheila Bair said that regulators were "all working together…to come at a solution and outcome that serves the public interest and I think we will have one today." The Solomon-like compromise offered by regulators—a split-up by geography, with Citigroup taking Wachovia's Northeast branches and Wells Fargo getting everything else—could be enough to appease Citigroup. The institution would get billions in low-cost deposits that provide it with a relatively stable source of funds.

If analysts are correct that the Wells Fargo-Citigroup battle marks the high-water mark in the current banking crisis, that doesn't mean that the remaining banks can rest easy. In her alert to clients, Bush notes that she's hearing from "many in the industry" that regulators have started to look beyond the current crisis and are assessing the prospects for other surviving banks—including many regional and local banks that engorged themselves on real estate loans—and don't like what they see.

Bush believes that if and when the current storm passes, regulators are still going to use their powers of persuasion to prod more of the surviving banks to merge. The goal: to flush weak management teams out of the industry and put more of the industry's assets into the hands of managers who have proven themselves most adept at managing risk. That means that even if Wells Fargo's $15 billion gambit does serve to stabilize the market, the mergers could continue for years to come.